Netflix, Inc.. Case Overview Comprehensive analysis of a growth company experiencing growing pains. Management claims them to be temporary growing pains.

Netflix, Inc.

Case Overview

Comprehensive analysis of a growth company experiencing growing pains.

Management claims them to be temporary growing pains

Stock market senses more chronic problems Case involves evaluation of competing

perspectives and conclusion regarding company’s prospects and valuation

Overview of Business

Rapidly growing DVD rental service, founded in 1998 and boasting 3 million subscribers by early 2005

Business model centers on mailing DVDs to customers using 35 warehouses spread around country.

Innovative pricing scheme whereby customers pay monthly subscription fee in return for unlimited monthly rentals. Most common plan is $18/month for up to 3 rentals at any point in time:– http://www.netflix.com

Steady growth in profitability through third quarter of 2004, but profitability slumps in fourth quarter of 2004

Business Strategy Analysis (1(i))

Sources of competitive advantage relative to traditional bricks and mortar DVD rental outlets– Comprehensive library of titles– Convenience of selection (personalized website

experience) and delivery (delivered to home by mail)

– Competitively priced for both ‘active’ users and users who typically incur late fees

Business Strategy Analysis (1(ii))

Sources of competitive advantage relative to web-based rental services– DVDs are currently most popular medium for

watching DVDs– Netflix’ early entrance to ‘online’ service has created

a first-mover advantage in the form of established subscriber base and brand recognition

– Netflix has established proprietary recommendation service to create a custom interface for each subscriber

Business Strategy Analysis (2)

Sustainability of Netflix’ Strategy Netflix strategy is fairly easy to replicate by existing

bricks and mortar competitors such as Blockbuster and DVD’s are likely to become obsolete as technology and acceptance of VOD and Internet downloading of movies improves.

Netflix potentially sustainable advantage is its large subscriber base. But switching costs are relatively low, so this is unlikely to lead to significant long-run sustainable advantage.

Accounting Analysis (3)

Accounting for the Rental Library at Netflix:– Prior to July 1, 2004, the Company amortized the cost of its

entire DVD library, including the capitalized portion of the initial fixed license fee, on a “sum-of-the-months” accelerated basis over one year. However, based on a periodic evaluation of both new release and back-catalogue utilization for amortization purposes, the Company determined that back-catalogue titles have a significantly longer life than previously estimated. As a result, the Company revised the estimate of useful life for the back-catalogue DVD library from a “sum of the months” accelerated method using a one year life to the same accelerated method of amortization using a three-year life.

Accounting Analysis (3)

Accounting for the Rental Library at Blockbuster:

– The cost of a non-base stock (or “new release”) DVD, both in-store and online, is amortized on an accelerated basis over a six-month period to an estimated $4 residual value. The cost of video games and in-store and online base stock (or “catalog”) DVDs is amortized on an accelerated basis over a twelve-month period to an estimated $5 and $4 residual value, respectively. The cost of new release VHS tapes is amortized on an accelerated basis over a three-month period to an estimated $2 residual value. The cost of catalog VHS tapes is amortized on an accelerated basis over a three-month period and then on a straight-line basis over a six-month period to an estimated $2 residual value.

Accounting Analysis (3)

Evaluation– Netflix’ amortizes its DVDs over a longer time

period. Are there differences between the two businesses that justify this difference?

– Given that Netflix is currently growing its DVD library, it will understate expenses and overstate earnings relative to the shorter and more conservative time period used by Blockbuster

– Recent switch by Netflix from 1 year to 3 years on back catalog looks like an attempt to manage earnings upward

Accounting Analysis (4)

Instead of amortizing the cost of the DVD library, Netflix would immediately expense the cost at acquisition. We can find both amounts in the Statement of Cash Flows:

Restated Operating Income = Reported Operating Income + Amortization of DVD Library – Acquisitions of DVD Library = 19,354 + 80,346-102,971 = -3,271

(Note: Alternative approach is to subtract the increase in the net DVD library on the balance sheet from reported operating income. This approach involves estimation error, because the DVD library is reduced by DVD sales as well as DVD amortization)

Accounting Analysis (5)

Netflix Provision for Income Taxes:– Netflix has a history of losses for both tax and financial

reporting purposes. These losses produce net operating loss carryforwards (NOLS) to offset against future profits. But given the uncertainty as to whether Netflix will ever generate enough profits to use these NOLS, they are booking a 100% valuation allowance against the associated benefits, resulting in zero tax benefit or expense. In other words, they are assuming that they will never have to pay any taxes, because they assume they will never have enough profit to offset their NOLs, and so they report no tax expense.

Ratio Analysis (6)

Subscription revenues are used in numerator, since DVD library generates subscription revenues

Rental library turnover ratio for Netflix = (500,611)/((22,238+42,158)/2) = 15.55

Rental library turnover ratio for Blockbuster = (4,428.6)/((457.6+354.4)/2) = 10.90

Ratio Analysis (7)

Major reasons for Netflix’ higher turnover ratio:– Netflix turns its library more frequently than Blockbuster. The

key reason for this difference is that Netflix’ library is centrally located at its 35 warehouses, while Blockbuster’s library is distributed across its 9,100 stores. This allows Netflix to more efficiently match rentals to customers. We can think of Blockbuster as being a product differentiator – as it provides the convenience on visiting a local store on the spur of the moment to pick up a rental. But Blockbuster pays for this through lower turns.

Ratio Analysis (8)

Note use of subscription/rental revenues and costs in these computations

Gross margin on movie rentals for Netflix = 1 – (273,401/500,611) = 45.4%

Gross margin on movie rentals for Blockbuster = 1 – (1,250.7/4,428.6) = 71.8%

Ratio Analysis (9)

Major reasons for Netflix’ lower gross margins:

– Blockbuster’s gross margins are much higher. The key reason is that Blockbuster has to charge a higher markup to cover the higher costs of its more differentiated, service-oriented approach. In particular, it needs to cover the costs associated with operating its 9,100 retail outlets.

– Note that extended viewing fees are a significant contributor to Blockbuster’s margins.

The following slide approximates the forecasting assumptions made by a prominent sell-side analyst in reaching the $0.34 and $1.13 EPS forecasts for 2005 and 2006 respectively.

Notes:– Use 5 year forecast horizon and valuation date of 3/1/2005. Valuation

parameters and forecasts beyond 2006 influence 2005 and 2006 EPS forecasts through assumed price at which 2005 and 2006 share transactions take place (see EPS Forecaster sheet)

– Analyst forecasts increase in CoGS because Netflix is required to reclassify fulfillment costs from SG&A to CoGS starting in 2005 and because Netflix implemented a price reduction at the end of 2004

– Analyst forecasts reduction in SG&A due to reclassification discussed above

Forecasting Analysis (10 & 11)

Forecasting Analysis (10 & 11)

Forecast Horizon TERMINALEstimated Price/Share=$15.99 YEAR

Forecast Forecast Forecast Forecast Forecast ForecastFiscal Year End Date 12/31/2005 12/31/2006 12/31/2007 12/31/2008 12/31/2009 12/31/2010

Implied Return on Equity 0.102 0.254 0.238 0.217 0.194 0.168

Income Statement AssumptionsSales Growth 36.4% 44.2% 34.4% 24.6% 14.8% 5.0%Cost of Goods Sold/Sales 42.2% 46.2% 46.2% 46.2% 46.2% 46.2%R&D/Sales 4.4% 3.9% 3.9% 3.9% 3.9% 3.9%SG&A/Sales 35.4% 34.0% 34.0% 34.0% 34.0% 34.0%Dep&Amort/Avge PP&E and Intang. 470.0% 309.0% 309.0% 309.0% 309.0% 309.0%Interest Expense/Avge Debt 64.4% 64.4% 64.4% 64.4% 64.4% 64.4%Non-Operating Income/Sales 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%Effective Tax Rate 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Minority Interest/After Tax Income 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Other Income/Sales 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Ext. Items & Disc. Ops./Sales 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Pref. Dividends/Avge Pref. Stock 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Forecasting Analysis (12)

Churn is defined on page 12 of Netflix 10-K. It is basically a measure of the proportion of existing customers that cancelled the service during a period of time. Fewer cancellations will lead to higher revenue (holding subscriber additions and subscription fees constant).

Valuation Analysis (13)

The default valuation is -$49.44/share. The negative valuation arises because the default assumptions

imply a terminal ROE of 3.6%, much lower than the cost of capital of 10%.

Note that negative prices are not observed in practice, but we get a negative value in eVal because the default forecasting assumptions imply that Netflix will raise even more cash from investors in the future to support aggressive growth. Since these future cash flows are negative NPV (invested to yield a return lower than cost of capital), a negative value is generated.

Note that the main cause of the negative valuation is the depreciation assumption. As growth slows, the depreciation rate will fall (since it is expressed as a % of average net PP&E balance and Netflix is using accelerated depreciation)

For example, lowering depreciation rate in terminal year to 400% increases terminal ROE to 21.6% and valuation to $150.06/share.

Valuation Analysis (14)

The following slide provides a set of forecasting assumptions generating a valuation of $12.07/share.

Starting point is the 2005 and 2006 forecasts used in the solution to Q. 10.

Depreciation rate is trended to 272% terminal rate. Note that this amount is reasonable, as rate is expressed as a % of net PP&E, and accelerated sum-of-months accelerated method is used over periods from 1 to 3 years.

Interest is trended to 7% terminal rate. Tax rate is trended to 35% terminal rate. Balance sheet assumptions left at eVal defaults.

Valuation Analysis (14)

Forecast Horizon TERMINALEstimated Price/Share=$12.07 YEAR

Forecast Forecast Forecast Forecast Forecast ForecastFiscal Year End Date 12/31/2005 12/31/2006 12/31/2007 12/31/2008 12/31/2009 12/31/2010

Implied Return on Equity 0.102 0.254 0.229 0.200 0.171 0.142

Income Statement AssumptionsSales Growth 36.4% 44.2% 34.4% 24.6% 14.8% 5.0%Cost of Goods Sold/Sales 42.2% 46.2% 46.2% 46.2% 46.2% 46.2%R&D/Sales 4.4% 3.9% 3.9% 3.9% 3.9% 3.9%SG&A/Sales 35.4% 34.0% 34.0% 34.0% 34.0% 34.0%Dep&Amort/Avge PP&E and Intang. 470.0% 309.0% 299.8% 290.5% 281.3% 272.0%Interest Expense/Avge Debt 54.8% 45.3% 35.7% 26.1% 16.6% 7.0%Non-Operating Income/Sales 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%Effective Tax Rate 0.0% 0.0% 8.8% 17.5% 26.3% 35.0%Minority Interest/After Tax Income 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Other Income/Sales 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Ext. Items & Disc. Ops./Sales 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Pref. Dividends/Avge Pref. Stock 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Valuation Analysis (14)

Overall evaluation of forecasting assumptions– These forecasts assume that Netflix can earn a

short-run ROE of 25% and a long-run ROE of 14% relative to its cost of capital of 10%.

– These forecasts also assume that Netflix can grow sales from $0.5 billion in 2004 to over $2 billion by 2010.

– These forecasts are very aggressive, particularly since competition is strong and DVD by mail is likely to be an largely obsolete technology by 2010.

Valuation Analysis (15)

Price target is set at 30x 2006 pro forma EPS. This is an ad hoc valuation technique that is not

grounded in sound valuation theory. No justification is used for either the multiple of 30 or the use of 2006 pro forma earnings.

It seems likely that 2006 will be Netflix ‘peak’ earnings year, after which time downloading of rental movies will pressure Netflix’ profitability, so 30 multiple on 2006 earnings is aggressive.

Wall Street Journal, September 6, 2006 Apple, Amazon to Unveil Movie Downloads Much-Anticipated Services To Sell Major Studio Releases; Slimmer Pickings at iTunes By NICK WINGFIELD in Seattle, SARAH MCBRIDE in Los Angeles and JESSICA E. VASCELLARO in New York September 6, 2006; Page D1

Movies on the small screen are about to receive a big boost as two high-profile companies -- Apple Computer Inc. and Amazon.com Inc. -- lift the curtain in the coming days on new movie-downloading services.

The services from the two companies are among the most widely anticipated efforts yet to get consumers to buy or rent videos over the Internet rather than trudging to the local Blockbuster store for a DVD or waiting for a Netflix envelope to arrive in the mail. Most legal movie downloading services haven't yet taken off. But within the high-tech and entertainment industries, there's a belief Apple and Amazon could help take the phenomenon mainstream thanks to their technology, marketing and retailing know-how.

Key Takeaways

Firms in the same industry can employ very different business models that have very different financial characteristics

Aggressive accounting methods can be used to inflate profitability during periods of high growth

Investors tend to be over-optimistic regarding the prospects of firms with ‘hot’ business models, but sustainability of these business models is often questionable